The inverted yield curve is surely a warning for equity investors

Throughout 2005 US equities drifted sideways, trading in a narrow band, and the Dow Jones Index ended the year almost unchanged from the start. But the absence of any major stock market downturn, particularly in the feared month of October, left some observers wondering whether the still booming economy was being ignored by the stock market.

Well, stock market try to discount futures, not the present, and that is why equities are listless despite the US economy still growing like there was no tomorrow. For debt is mounting and structural imbalances persist that markets know can not go on forever, tomorrow always comes.

Eventually the US consumer has to begin to flag. House prices are beginning to slow and pullback and that is signaling an end to the use of home equity as a kind of cash machine for consumer spending.

Inverted yield curve

Now what the inverted yield curve signals is that bond holders do not believe that the Federal Reserve will be able to hold interest rates at present levels for very long. Something is going to give way and force the Fed to undo its rate tightening.

Energy prices, higher interest rates and falling house prices are inevitably going to weaken the US consumer and consumer spending is what mainly drives the US economy these days. This is not going to be good news for stocks.

Financial shares have already begun to weaken, as the difference between the short and long term yield is the profit margin of the sector, and it has just vanished. Once investors perceive that the good news for profits is coming to an end, they may all decide to sell stocks.

This is the classic formula for a stock market crash, or major correction. Perhaps just because last October did not produce a crash as some expected, Wall Street decided that there was not going to be one. But is it not more likely that the evil day of reckoning was just postponed?

For the US stock market rally since the nadir before the invasion of Iraq is now very long in the tooth. Everyone knows that stock markets move up in bull phases and then down in bear phases, and we are already overdue for a change of direction.

Exit stocks early?

The intelligent investor would surely look hard at equity holdings right now in all major stock markets for when the US catches a cold, those who depend on trade with the US may come down with pneumonia.

Such a market downturn would also spread to the energy sector. Indeed, a serious US recession is probably the only thing that can trip-up the present bull market for oil and gas prices.

The response of the Federal Reserve would doubtless be to flood the market with cheap money - and it has already conveniently ended the publication of M3 money supply figures from March - but US consumers might finally take fright and stop spending if they are worried about the economy, and that would be a self-fulfilling prophesy.